Tuesday, January 26, 2010

Eurozone Imbalances Weaken Trust in The Euro and Undermine Euro Area Cohesion

This is the conclusion drawn - rather surprisingly - not by some bank analyst, or by a Credit Ratings Agency, but by the European Commission itself, according to the contents of a report "leaked" to the German magazine Der Spiegel at the end of last week. "(The imbalances) weaken trust in the euro and endanger the cohesion of the monetary union,".

Here is a rough translation of the Der Spiegel report:

The EU Commission Sees Monetary Union At Risk

The EU Commission is concerned about the survival of monetary union. The differences in competitiveness between member countries and the resulting imbalances give "cause for serious concern for the eurozone as a whole", according to a presentation given by the Directorate General for Economy and Finance to the finance ministers of the Eurogroup.

The experts who advise the Finnish Commissioner-designate Olli Rehn fear that the differential development of the economies in the various Member States undermine confidence in the euro and may ultimately threaten the cohesiveness of the monetary union. Of particular concern to the Brussels officials is the economic condition of those countries who in the past ran huge deficits in their current account balances, because they lived for many years thanks to ample credit which was avaialable due to the low interest rates prevailing. Now these countries are suffering, especially Spain, Greece and Ireland, under the weight of escalating government deficits. "The combination of declining competitiveness and excessive accumulation of public debt worrying in this context," the experts say.

As a way out of trouble, the EU officials first propose that the countries concerned put their own houses in order and introduce the necessary reforms. Wage levels need to be set with due consideration to falling productivity and the loss of competitiveness. In plain language: workers ambitions should be modest, with low wage settlements. "The adjustment will be accompanied by a marked increase in unemployment."

The Commission officials also recommend that the deficit countries employ a strategy which was used by Germany in its recent efforts to exit from many years of weak growth. At the same time the German federal government does not escape criticism in the report, since Germany and other relatively successful countries such as Austria and the Netherlands need to tackle the chronic weakness in their domestic demand.

To achieve this the Brussels experts recommend enabling more competition in the services sector, the intriduction of tax reforms and the elimination of credit hurdles. The longer the countries concerned delay introducing the necessary measures, the higher the social costs which will be incurred. The Commission believes the euro countries have no choice: "These adjustments are vital for the long-term functioning of monetary union."

As far as can be seen from this Spiegel report, while it is the case that some of the wording used is similar to things we have seen before, there would seem to be an underlying transition going on here, one which in EU terms is quite rapid. The EU's own analysis of the problems in the Eurozone is coming nearer and nearer to that of both the IMF and the credit rating agencies. We are moving beyond short term fiscal deficit issues, and immediate liquidity issues, towards problems like competitiveness, and what was previously a taboo subject - the issue of Eurozone imbalances. These were, in fact, supposed to disappear with the passage of time, so it was expected that they would have diminished rather than increased. In that sense there is now an implicit admission that the institutional environment in which the common currency has been operated was severely deficient and badly needs to be improved. In my view this change in approach is already a big improvement, as is the fact that people are begining to face up to the reality that the Euro has exacerbated the imbalances, rather than reducing them.

In particular the Commission seem to be starting recognising that countries like Spain whose main export became pieces of paper (or IOUs on their future) which were securitised against assets which we can now see didn't have the value they were thought to have (the housing stock, or should I say glut) entered a dynamic which was seriously unstable. Now we need to see the measures which can be applied for correcting these distortions.

Stark told the Welt am Sonntag newspaper that Greece, which is battling to get its budget under control, must make comprehensive consolidation a priority but also reform its economy to stop producing deficits. "Countries like Greece must not only bring their deficits under control, but also enact a fundamental reorientation of their economic policy," Stark said. "Some countries have even managed to accept falling wages -- there is no alternative for economies in a difficult situation," he added in the interview, which had been held on Thursday.

The reference in the Spiegel report to the earlier German expience is to the earlier "internal devaluation" Germany carried out between 2001 and 2005 in an attempt to restore competitiveness after having entered the common currency at an exchange rate which was later discovered to have been too high. The thing is, the German devaluation was quite limited and quite slow. Greece and Spain have large devaluations to carry out, and the time scale is likely to need to be short, since it is urgentto restore growth to these economies to avoid the debt to GDP percentages snowballing upwards.

Another aspect to this whole problem is the new emphasis on correcting the imbalances as a shared process, one which, as Mr Zapatero would have it, involves "solidarity", and joint responsibility. That is to say the surplus countries are going to be expected to play their part: no wonder the German economy minister became so angry with Mr Zapatero's 2020 strategy initiative.

Of course, it is not really posible to present the problem in quite this way, since one set of economies are competitive, and another set are not, so it is hard for the Greeks and the Spanish to really blame the Germans and the Dutch for their present situation, although everyone, both centre and periphery, will have to play a part in the search for solutions. I tend to put it this way: the South must make sacrifices, and then the centre must help. Thus talk of no "financial bailout being possible", or, as M Trichet would have it, simply stating that the "external surpluses of some member countries (in the balance of payments) finance the external deficits of some others" without recognising that the presence of these very same surpluses form a problematic part of the internal Eurozone imbalances is hardly helpful at this point.

As Martin Wolf said recently:

What people do not seem to understand is that peripheral European countries cannot escape from their trap because they are caught in a game of competitive deflation with Germany (and the Netherlands). So long as the eurozone has an external balance (roughly) and Germany has a vast surplus, the rest of the zone MUST be running aggregate deficits. That is a subtraction from their domestic demand. This then means that either the private sector runs deficits (spends more than its income) or the public sector does. If the latter is pushed towards balance, by eurozone pressure, GDP must contract enough to force the private sector finally back into deficit and so towards bankruptcy. Ultimately, the only way out of the trap is for nominal wages and costs in peripheral Europe to fall so much that it forces core Europe into depression . That also means a depression in peripheral Europe. No advanced polity can cope with a permanent depression. Anything can then happen. I have always feared that the euro could break the EU. I believe this is quite possible.

"Alternatively, demand must start to rise substantially in core Europe. Is that possible? The other alternative would be for the eurozone as a whole to move into surplus - but how, given the weakness of external demand and the strong euro?"

No easy answers yet awhile, but lots of interesting problems to talk about, and plenty of food for thought.